Q3 2019 - Year-End Considerations for Fund Managers

September 19, 2019

By Marc Stahl

The Tax Cuts and Jobs Act (TCJA) introduced several Internal Revenue Code (IRC) Sections -- 163j, 199A, 461(l) and 1061 -- that directly affect the financial services industry. At this time, we are still awaiting regulations and guidance for IRC Sec.1061 incentive allocations and IRC Sec. 461(l) excess business losses. As year-end approaches, we are highlighting several issues that fund managers should consider.

IRC Sec.1061, relating to partnership interests held in connection with performance of services, also known as carried interests or carry, changed the required holding period to achieve long-term capital gain tax rates from one year to three years. To clarify, long-term capital gains allocated to the general partners (GPs) from a carry allocation are now required to have a holding period of greater than three years to achieve long-term preferential status. Long-term capital gains allocated based on capital contributed retain the one-year holding period. We are still awaiting clear guidance from the U.S. Department of Treasury for the definition of what is required to be held greater than three years in order to qualify as long-term capital gain. Is it the applicable partnership interest and the underlying security sold by the partnership? Or, if the underlying security meets the three-year rule, does it qualify as long-term capital gain treatment regardless of the holding period of the applicable partnership? Further guidance is also necessary to define capital contributed, leaving us with this question: If the GP could have withdrawn the capital, does this qualify as capital contributed?

IRC Sec. 1061 is also vague when speaking to IRC Secs. 1256 and 988 assets. Pending regulations, industry practice is that the three-year holding period requirement is not applicable to these types of assets. Funds should consider when investing in IRC Sec.1256 assets, which are taxed as 60/40 long-term/short-term capital gain/loss regardless of holding period, or making an IRC Sec. 988 (a)(1)(B) election that allows the fund to treat the recognition of an IRC Sec. 988 asset as capital gain/loss, if the recently enacted three-year rule applies or if it coincides with its strategy.

Miscellaneous itemized deductions subject to a 2% of adjusted gross income limitation are now disallowed on the individual level. This includes IRC Sec. 212 portfolio deductions, directly affecting investor funds. Investor fund expenses are classified as IRC Sec. 212 expenses subject to the 2% adjusted gross income (AGI) limitation, leaving partners of these funds to pay tax on gross income. Prior to enactment, individuals subject to the alternative minimum tax (AMT) were disallowed the benefit of these expenses; however, as of 2018, there is no potential for a benefit to be received. The tradeoff of the limitation on portfolio expenses is that the fund is realizing long-term capital gain, taxed at a lower tax rate in exchange for some losses disallowed.

Fund managers have discussed converting to passive foreign investment company (PFIC) structures in order to pass through the fund’s expenses. This will allow investors to make a qualified electing fund (QEF) election, include net ordinary income in the current year, while preserving long-term capital gain. The downsides to this structure are that only net gains are passed through, with net losses being disallowed, and there are additional foreign filing requirements that a U.S. investor needs to report with its return.

With the addition of IRC Sec.1061 requiring securities to be held greater than three years for carry allocations, investor funds GPs are now paying ordinary tax rates on gross income versus long-term capital rates. This has resulted in some unfortunate outcomes for 2018, where the tax liability has exceeded the carry earned. Consider: Investor fund A earned net $50 of incentive allocation. This amount consists of $200 short-term capital gain and $150 of IRC Sec. 212 portfolio deductions. For cash purposes, the GP is receiving $50. However, due to the elimination of miscellaneous itemized deductions, the GP is remitting tax on $200 of short-term capital gains. With a federal tax rate of 40.8% (ordinary rate + NII), $82 of tax is required to be remitted to the IRS, which is $32 more than received in cash. In light of these changes, there are alternative options that could be considered. For example, the GP could consider converting to a C corporation. Salaries would be paid out of the C corporation, along with all other ordinary and customary expenses, such as IRC Sec. 212 portfolio deductions. The salaries will be taxed at ordinary rates; however, unlike in a flow-through structure, portfolio deductions are allowable deductions for C corporations, and will not be lost. Using the example above, the C corporation will incur a salary expense of $50, of which the GP will pay tax on versus the $200 required if based on a direct allocation. Please be advised that restructuring to a C corporation is complex. Consulting your tax advisor is a must prior to converting to a complex structure. Alternatively, the GP could also consider waiving the carry when the tax liability exceeds the incentive earned. Consult your tax advisor prior to year-end in order to consider all facts and consequences pertaining to waiving the incentive fee allocation.

The newly enacted IRC Sec. 461(l) limits excess business losses of non-corporate taxpayers. The limitation is applied on the individual level, limiting aggregate business income and losses to $250,000 ($500,000 if married filing joint). This provision includes both trader and IRC Sec. 475 mark-to-market funds. It is even more important now to address year-end planning, as this limitation has the potential to greatly impact an individual’s tax liability. Historically, fund managers have utilized loss harvesting, generating additional losses against current gains, mitigating their income tax liability. In the post-tax reform era, trader funds with excess losses should consider gain harvesting, as investors may be limited on the loss allowance in the current year. Please keep in mind this limitation is on the individual level, and the fund may not have the ability to determine if the ultimate taxpayer is in a gain or loss position.

Additional Compliance Update for the Back Office.

Foreign Withholding/Form 1042

For periods after December 31, 2017, Form 1042, Annual Withholding Tax Return for U.S. Source Income of Foreign Persons has been updated. Foreign investors are now required to provide foreign tax identification numbers (FTINs) as well as the date of birth reflected on an executed Form W-8 BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting (Individuals). The U.S. Treasury Department and the IRS intend to amend the temporary regulations to provide an exception to this requirement, such that an otherwise valid withholding certificate signed before January 1, 2018 will not be treated as invalid for payments made before January 1, 2019 to an account holder that is an individual, solely because the withholding certificate does not include the account holder’s date of birth and the date of birth is not in the withholding agent’s files. This allowance is provided to give withholding agents additional time to comply with the date of birth requirement for withholding certificates signed before January 1, 2018. In addition, the U.S. Treasury Department and the IRS intend to amend the temporary chapter 3 regulations to clarify that a withholding agent will be considered to have the account holder’s date of birth in its files if it obtains the date of birth on a written statement (including a written statement transmitted by email) from the account holder.

For Entities Requiring FTINS:

Phase-In of Requirement to Obtain an FTIN Under Treasury Regulation Sec. 1.1441–1T(e)(2)(ii)(B)

The Treasury Department and the IRS intend to amend the temporary chapter 3 regulations to provide additional time for a withholding agent to comply with the requirement to obtain an FTINI to be phased-in over a period ending on December 31, 2019.

For Form W-8 received during the phase-in period, the Notice provides an alternative procedure for obtaining an FTIN (or a reasonable explanation for why the account holder was not issued an FTIN) for a withholding certificate signed before January 1, 2018. If a withholding agent obtains the account holder’s FTIN (or a reasonable explanation for why the account holder was not issued an FTIN) in accordance with the alternative procedure (rather than obtaining a new withholding certificate), an otherwise valid withholding certificate will remain valid after the end of the December 31, 2019.

As of January 1, 2020, there are additional new rules going into effect, regarding Form 1042 reporting. There are now two filing dates for Form 1042-S: March 15 for payments made before March 1, 2020 and September 15 for payments made after March 1, 2020. The IRS has also indicated it plans to audit more entities on their compliance and internal control procedures in regards to their withholding obligations. We strongly recommend that funds make sure they have valid W-8/W-9 withholding forms from its investors. W-9 forms never expire and W-8 forms are valid for a maximum of three years.

Marc Stahl is a Tax Director in the Financial Services Group with years of experience in the financial services sector focusing on financial services and investment management entities to both start-ups and well-established clients.